Exchange Traded Funds (ETFs) are investment vehicles that investors can buy and sell to gain approximate exposure to the net asset value of the underlying index.
A commodity (e.g., pork bellies, rice, wheat, aluminum) defines a good for which there is demand but which is not readily differentiated across the marketplace. Certain companies track commodity prices; for example the Goldman Sachs Commodity Index (GSCI) is an investment performance benchmark tracking global commodities, weighted by liquidity and global production levels. Commodities thus also indicate marketplace economics.
Many companies invest in commodities to function and manage unknown price fluctuations. These companies thus often employ the derivatives market to hedge fluctuations in commodities prices using futures contracts (“futures”). Variable prices may also be traded for fixed prices, and vice versa, in commodity “swaps”. A commodity swap is exceptionally useful in hedging against price risks by exchanging cash flows without physical delivery of the commodities. In operation, companies that use commodities agree to a fixed price with a counterparty for a pre-agreed period. At the settlement date, if the market price is lower than the agreed-to price, the company pays the counterparty the difference; if the market price is higher, the company receives the difference from the counterparty.
Investors also invest in commodities to capitalize on price movements. A common way for these investors to invest in (a) commodities is to invest in securities of companies which own or process commodities, (b) invest in Futures, Options or ETFs that track commodities, commodity performance, or commodity indices (e.g., GSCI), or c) invest in mutual funds which invest in commodities or related securities.
The character of income derived from commodity instruments such as futures or swaps, when packaged in a partnership, commonly results in capital gains or income reported in a “K-1”. A K-1 is used in partnerships, LLCs and sub-chapter S corporations and refers to the Internal Revenue Service (IRS) form used to report an owner's share of income and expense items. A K-1 adds complexity to tax reporting and can greatly increase the cost of investment due to calculation and reporting requirements associated with the K-1.